Petroleum Inc.(PI)controls offshore oil leases.It is considering the construction of a deep-sea oil rig at a cost of $500 million.The price of oil is $100/bbl.and extraction costs are $50/bbl.PI expects costs to remain constant.The rig will produce an estimated 1,200,000 bbl.per year forever.The risk-free rate is 10% per year,which is also the cost of capital.(Ignore taxes).Suppose that oil prices are uncertain and are equally likely to be $120/bbl.or $80/bbl.next year.Calculate today's NPV of the project if it were postponed by one year.
A)+$100 million
B)+$154 million
C)+$170 million
D)+$187 million

Question

Quizplus · Accepted Answer

If the project were postponed for a year, the oil rig would not be operational for another year. Therefore, we would not receive any cash flow in the first year. In the second year, there is an equal chance that the oil price would be $120 or $80 per barrel. Therefore, the expected revenue in the second year would be:

Expected Revenue = 0.5 x 1,200,000 x $120 - $50 x 1,200,000 x 0.5 + 0.5 x 1,200,000 x $80 - $50 x 1,200,000 x 0.5
Expected Revenue = $66 million

Therefore, the total expected revenue over two years would be:

Total Expected Revenue = $0 + $66 million
Total Expected Revenue = $66 million

The NPV of the project can be calculated as follows:

NPV = - $500 million + ($66 million / 1.1)
NPV = - $500 million + $60 million
NPV = -$440 million

This is the NPV if the project is postponed for a year. To calculate the NPV if the project is undertaken immediately, we can use the expected revenue in the first year, which is $60 million (based on an oil price of $100 per barrel). Therefore, the NPV of the project if undertaken immediately would be:

NPV = - $500 million + ($60 million / 1.1) + ($66 million / 1.1^2)
NPV = - $500 million + $54.55 million + $57.22 million
NPV = -$388.23 million

Comparing the two NPVs, the NPV if the project is postponed for a year is worse than if the project is undertaken immediately. Therefore, the best choice is to undertake the project immediately, and the answer is B.